Less Efficient Markets = Higher Alpha?



Students often ask me for career advice. It’s not a particularly satisfying experience. On the one hand, these are often exceptionally bright and hard-working people, with an Oxford or Cambridge PhD in chemical engineering, astrophysics, or some other challenging discipline. I wish they stick to science and create something meaningful to our civilization, not try to generate a few extra basis points every year.

On the other hand, some students soon decided to pursue a career in finance and study accordingly. There is no point in asking them to make better fertilizers or rocket ships. But providing finance career advice is becoming harder and harder. Why? Because global capital markets are already highly efficient and each day machines are grabbing more and more market share from humans. The career prospects for someone with a master’s degree in finance and some basic Excel skills are steadily decreasing.

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Naturally, it depends on the role. Most of the students dream of becoming a fund manager and managing money. Exchange traded funds (ETFs) have become their major competitors. So if a fund manager career is aspirational, perhaps focusing on less efficient markets, either private or equity niches, is sensible career advice.

After all, fund managers should theoretically be able to extract more alpha from such markets. Of course, in the investing world, reality often deviates substantially from theory. So how have fund managers performed in less efficient stock markets?

Alpha Generation in US Equity Markets

To answer this, we first examined the ability of fund managers to create alpha in the US equity markets. S&P’s SPIVA scorecard gives a good insight into the performance of mutual fund managers.

They paint a gloomy picture: 82 percent of US large-cap mutual fund managers failed to beat their benchmark in the 10 years between 2010 and 2020. From 2000 to 2020, an astonishing 94% failed to do so.

Given that the S&P 500 constituents are the most traded and researched stocks on earth, this is probably to be expected. However, US small-cap fund managers didn’t outperform: Despite all the hidden gems, 76% outperformed their benchmarks over the past 10 years.

Most capital allocators believe that expert knowledge has value. Real estate stocks (REITs) are somewhat unusual instruments because they have characteristics of the stocks, bonds and real estate industries. Theoretically, such sectors should provide rich alpha opportunities for dedicated fund managers. Alas, these markets also tend to be very efficient in the United States. More than three out of four REIT fund managers – 76 per cent – could not beat their benchmark.

US Equity Mutual Funds: Percentages Underperforming Their Benchmarks

Chart showing US equity mutual funds: Percentages underperforming their benchmarks
Source: S&P SPIVA Scorecards 2020, FactorResearch

exploiting less efficient markets

Compared to their US counterparts, emerging markets are less regulated and company data is not always evenly disseminated. Information asymmetries are high and many markets, among them China, are dominated by retail investors. Overall, this should allow sophisticated fund managers to create substantial value for their investors.

But when we compare equity mutual fund managers in developed and emerging markets, both have fared poorly. For developed market fund managers, 74 per cent underperformed their benchmark in the three years ending 2020, compared to 73 per cent for emerging market fund managers.

Equity funds underperforming their benchmark in the last three years

Chart showing the underperforming equity funds of their benchmark over the last three years
Source: S&P SPIVA Scorecards 2020, FactorResearch

Although investors choose mutual funds based on three-year performance data, it is a relatively short duration, and may not cover the full boom and bust market cycle. Perhaps fund managers need more time to prove their skills and be evaluated over a longer time horizon.

Unfortunately, increasing the observation period does not improve perspective. Mutual fund managers in emerging markets performed slightly worse than their counterparts in developed markets. Over the past five years, 84% underperformed their benchmark, compared to 80% for developed market fund managers. And over the past 10 years, 85% underperformed emerging markets, while 82% underperformed their developed market counterparts.

Equity funds underperforming their benchmarks: Developed vs Emerging Markets

Chart showing when equity funds are underperforming their benchmark: Developed vs. Emerging Markets
Source: S&P SPIVA Scorecards 2020, FactorResearch

performance consistency

To be honest, the lack of alpha generation from mutual fund managers is nothing new. This has been flagged by academic research for decades. Capital allocators emphasize that it is all about identifying the few funds that consistently generate additional returns. This is an interesting point to evaluate in emerging markets. Given the high information asymmetries compared to developed markets, fund managers should have more opportunities to gain a competitive edge.

The S&P also provides data on performance stability: it paints a really gloomy picture for US equity mutual funds. For example, only 3% of the top 25% of funds in 2016 managed to stay in the top quartile the following year. In the four-year period, less than 1% did. Stated differently, there is no performance stability.

Conversely, emerging markets show some performance stability over the next year. A random distribution would assume that 25% of the funds in the top quartile can maintain their positions, and that a higher percentage of funds are received in Brazil, Chile and Mexico.

In subsequent years, however, this percentage decreases, indicating that almost no fund exhibits performance stability. It seems that the best performing mutual funds lack a competitive edge in the stock markets.

Performance Consistency: Percentage of 2016 Top Quartile Funds Remaining in the Top Quartile

Chart showing performance consistency: percentage of 2016 top quartile funds remaining in top quartile
Source: S&P SPIVA Scorecards 2020, FactorResearch

emerging market hedge funds

Most emerging market mutual fund managers failed to outperform, and those who did were fortunate rather than skilled because of a lack of consistency. Perhaps being constrained to a set of stocks from the benchmark index is not conducive to alpha generation.

So what if we evaluate the performance of emerging market hedge funds that are relatively unrestricted? Overall market conditions do not matter as these funds can go long and short in equities, bonds and currencies.

But even these highly sophisticated investors have struggled to beat their benchmarks. The HFRX EM Composite Index shared a trend similar to the MSCI Emerging Markets Index in performance, albeit with less volatility. Returns were essentially zero since 2012, except for growth in 2020, which reflects a COVID-19 stock rebound, which indicates beta rather than alpha.

Emerging Markets Hedge Funds Vs Equities and Bonds

Chart showing emerging market hedge funds versus equities and bonds
Source: HFRX, Factor Research

further thoughts

Emerging markets are less efficient capital markets than developed markets with large information asymmetries. Microsoft is covered by over 30 Wall Street research analysts and by Amazon over 40. No EM stock is tested equally, and most completely lack institutional research coverage.

So why are emerging market mutual fund managers not able to take advantage of this?

Tile for future work in investment management: the 2021 report

Management fees certainly reduce alpha, but the primary reason is that it’s difficult to choose a stock regardless of the market. There may be more opportunities for alpha in emerging markets, but the risk is also higher. Argentina managed to sell off 100-year bonds in 2017, and Mozambique issued bonds in 2016 to finance its tuna fleet. No country could manage it today. Fortunes change rapidly in emerging markets where stability is less certain, which makes forecasting redundant.

This means that focusing on the less efficient stock markets is not a particularly good career move, at least for those pursuing fund management. The smartest advice is probably to follow the money that is being poured into private markets such as private equity and venture capital. These are complex asset classes that are difficult to benchmark and calculate whether the products provide value. Complexity may be the enemy of investors, but it is the friend of asset management.

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All posts are the views of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image Credits: © Getty Images / Mats Anda

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Nicholas Rabner

Nicolas Rabner is the Managing Director of Factor Research, which provides quantitative solutions for factor investing. Prior to that he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Prior to this, Rabner worked at GIC (Government of Singapore Investment Corporation), which focused on real estate across asset classes. He began his career working for Citigroup in investment banking in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100 km ultramarathon, Mont Blanc, Mount Kilimanjaro).

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